My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. My posts are blunt, opinionated and even have a twist of humour/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.
Showing posts with label corporation. Show all posts
Showing posts with label corporation. Show all posts

Monday, January 10, 2022

RRSPs and Corporations - Your Silent Creeping Tax Liability

Happy New Year and I hope 2022 brings you and your family good health and a quick return to something resembling normality. This is my first blog post since December 31st when I officially retired from my public accounting firm. The term “retired” is used loosely. I look at it as a bit of a sabbatical after almost 40 years in public accounting. I will be looking for a new opportunity outside the public accounting realm in accordance with the terms of my retirement agreement, possibly in the family office, multi-family office or investment manager space; I am too young (at least in my own mind) to full stop retire.

Back to the topic at hand. In late December I was updating a retirement spreadsheet I have for changes in my current circumstances and future income tax minimization. 
 
In reviewing the income tax section of the spreadsheet, the quantum of my future or "deferred" tax liability struck me once again. Whether you are currently working, near retirement or in retirement, you have silent creeping tax liabilities accumulating in your Registered Retirement Savings Plan ("RRSP") and/or corporation [for me, in my professional corporation ("PC")]. In my experience, we tend to "forget" or minimize this tax liability, so I though I would discuss it today.

RRSPs are Great while you are Working, not as Great when you Retire


I think most readers will know this, but to quickly recap, contributions to a RRSP result in a tax deduction in the year made (or subsequent year if you don’t fully claim the contribution) and your RRSP grows tax-free until you convert the RRSP by the end of the year you turn 71. For most people, a RRSP works well as their contributions are made at a time their marginal tax rate is higher than they expect in retirement, so they have an ultimate tax savings. Despite the tax effectiveness of your RRSP, the value is somewhat of an illusion, as you are also accumulating a large, deferred tax liability, as the entire value of your RRSP will be taxable in your retirement.

There are a couple options for a RRSP when your turn 71, including a lump sum withdrawal, the purchase of an annuity or the option most people select, converting their RRSP into a Registered Retirement Income Fund (“RRIF”).

Once you convert your RRSP into a RRIF any future withdrawals are subject to income tax (you are now paying tax on your accumulated lifetime contributions and earnings that were tax-free in your RRSP) a sometimes nasty surprise in quantum for some people. You must start drawing your annual minimum RRIF payment by December 31 of the year following the year you establish your RRIF. Since you will typically still be 71 the year following the establishment of your RRIF, the minimum withdrawal will be 5.28% (you may be able to use your spouses age to lower the withdrawal rate) and will rise each year to around 10.2% by 88 and the withdrawal rates will continue to rise dramatically after age 88.

Each year this minimum withdrawal will be taxable on top of any old age security, CPP, pension income and any other investment or other type of income you earn. The marginal tax rate on these RRIF withdrawals can be substantial depending upon your financial circumstances. Luckily for many, you can elect to split your RRIF pension income with your spouse (Form T1032 -Joint Election to Split Pension Income) and thus, you can often lower your effective family tax rate through this election. However, even with the election, the deferred tax hit on your RRIF withdrawals can still be substantial.

Corporations – You have only Paid Part of the Tax


As noted above, I was struck by the quantum of my tax liability for not only my RRSP, but the investments retained in my PC. For purposes of this discussion, consider a PC to be the same as any corporation you may have. Most active companies will have paid corporate tax historically anywhere from say 12% to 26%, depending upon the corporate province of residence. You have thus deferred anywhere from say 20%-40% in tax by keeping the earnings in your corporation (again depending upon the province). Assuming you need to take money from your corporation in retirement, you will then have to deal with this deferred tax liability when you take the money (typically as a dividend).

Similar to a RRIF, you will owe income tax on this deferred tax (the deferred tax is less than your RRIF, since the corporation paid some tax, whereas you paid no tax on your RRSP). If you have been earning investment income in your corporation, you may have some tax attributes like refundable tax to reduce your tax liability, but the original money earned and deferred by the original active company is still subject to a tax hit even though it is now co-mingled with investment income earned on these deferred earnings. Without getting technical, you still have a large, deferred tax liability as you withdraw funds from your corporation.

Income Taxes and Your Retirement Withdrawal Rate


I have written a couple times on how much money you need to retire. In 2014, I wrote an extensive six-part series titled How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! (The links to this series are under Retirement on the far-right hand side of the blog). 
 
I updated this series between January and March 2021. Most of my various retirement articles and series revolve around the 4% Withdrawal Rule, which is one of the most commonly accepted retirement rules of thumb. Simply put, the rule says that if you have an equally balanced portfolio of stocks and bonds, you should be able to withdraw 4% of your retirement savings each year, adjusted for inflation, and those savings will last for 30-35 years.

In Part 1 of the original 2014 series, I had a section on some of the criticisms of the 4% rule. The first and the most impactful limitation being the model does not account for income taxes on non-registered accounts and registered accounts Note: many of the studies I discuss in both 2014 and again in 2021, still support that the 4% withdrawal works despite any income tax limitations, but I thought it important to reflect this limitation of the rule.
 
I plan to write a future blog post on possible tax planning that you can consider to minimize the tax hit from your RRSP/RRIF and corporation in retirement.
 
As discussed above, where you have a RRSP and/or corporation, income taxes are a creeping liability. Thus, it is important to ensure that when you are younger, you are cognizant of these taxes and as you get closer to retirement, you ensure you have a financial plan that accounts for these deferred/creeping taxes.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Monday, August 29, 2016

The Best of The Blunt Bean Counter - Proprietorship or Corporation - What is the Best for Your (New) Business?

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a November, 2011 blog post on whether you should incorporate a new
or start as a proprietorship?  I also address the logical follow-up question for those that have already started their business as a proprietorship:  when should they convert their proprietorship into a corporation?

Proprietorship or Corporation - What is the Best for Your (New) Business?


Corporation – Non-Tax Benefit


The number one non-tax reason to incorporate a business is for creditor proofing. Generally, a corporation provides creditor protection to its shareholder(s) through its limited liability status, a protection not available to a proprietorship. (It is important to note that certain types of professional corporations while protecting your personally from corporate liability, do not absolve the individual professional from personal professional liability). Where an incorporated business is sued and becomes liable for a successful claim, the only assets exposed to the creditors are the corporate assets, not the shareholders personal assets.

In order to mitigate the exposure that a potential claim could have on corporate assets, a holding company can be incorporated. Once the holding company is incorporated, the active corporation can transfer on a tax-free basis the excess cash and assets to the holding company (as discussed in my blog creditor proofing corporate funds) to insulate those assets from creditors. The assets in the holding company cannot be encroached upon if there is a lawsuit against the operating company unless there was some kind of fraudulent conveyance.

The inherent nature of certain businesses leads to the risk of lawsuits, while other business types have limited risk of a lawsuit. Thus, one of your first decisions upon starting a business is to determine whether your risk of being sued is high and if so, you should incorporate from day one.

Corporation – The Tax Benefits


There are several substantial income tax benefits associated with incorporation:

1) The Lifetime Capital Gains Exemption

If you believe that your business has substantial growth potential and may be a desirable acquisition target in the future, it is usually suggested to incorporate. That is because on the sale of the shares of a Qualifying Small Business Corporation, each shareholder may be entitled to a $824,177 capital gains exemption. So for example, if you, your spouse and your two children are shareholders of the family business (often through a family trust), you could potentially sell your business for $3,300,000 tax-free in the future. It should be noted that typically businesses that are consulting in nature, have limited value, since the value of the company is the personal goodwill of the owner.

Where you start your business as a proprietorship, it is still possible to convert the proprietorship into a corporation on a tax-free basis and to multiple the capital gains exemption going forward. A couple of points are worth noting here: (1) incorporating a proprietorship after the business has been operating for a few years may result in substantial legal, accounting and valuation fees; and (2) the value of the business up to the date of incorporation will belong to you and will be reflected in special shares that must be issued to you (assuming you will include other family members as shareholders in the new corporation).

For example, let's say you operate a successful business which you started as a proprietorship because you were unsure of whether it would be successful. The business has taken off and you have engaged a valuator to value the business prior to incorporating. The valuator has determined that the fair market value of your business today is worth $500,000. Upon incorporation, the $500,000 of value would be crystallized in special shares that would be owned by you. The new common shares that would be issued would only be entitled to the future growth of the business above and beyond the $500,000 and thus, any future capital gains exemptions for the new common shareholders would only accrue on the value in excess of $500,000.

2) Income Splitting

A corporation provides greater income splitting opportunities than a proprietorship. With a corporation it is possible to utilize discretionary shares that allow the corporation to stream dividends to a particular shareholder or shareholders (e.g. a spouse or a child 18 years of age or older) who are in lower marginal income tax brackets than the principal owner-manager.

Dividends are paid with after-corporate tax dollars from the business, whereas salaries, the alternative form of remuneration, are paid with pre-tax dollars and are generally a deductible business expense. The deductibility of a salary by a business is subject to a “reasonability test”. In order to deduct a salary from the business’ income it must be considered “reasonable”. Unfortunately, there is no defined criteria as to what is considered “reasonable”; however, paying a family member a salary of $50,000/annually who has little or no responsibilities within the business is likely not “reasonable”. However, with dividends there is no such “reasonability test”, so paying a family member a dividend of $50,000 even though she/he may have little or no responsibilities within the business is perfectly acceptable. Salaries to family members can be paid in an incorporated business or unincorporated business; however, the dividend alternative is unique to a corporation. Sole proprietors cannot pay themselves a salary; they receive draws from the proprietorship.

3) Income Tax Rate

The first $500,000 of active business income earned in a corporation is currently subject to an income tax rate of only 15.0%  in Ontario. Since the personal rate on income can be as high as 53.53%, income earned within a corporation potentially provides a very large income tax deferral, assuming these funds are not required personally for living expenses. This potential 38% deferral of income tax allows you to build your business with pre-tax corporate dollars. It should also be noted that once you take the money from the corporation, in many cases you essentially pay the deferred 38% tax as a dividend.

Corporations – The Fine Print


1) Expenses

Many people want to incorporate their business because they feel they will be able to deduct many more expenses in a corporation. In a general, that is an income tax fallacy. For all intents and purposes, the deductions allowed in a proprietorship are virtually identical to the deductions permitted in a corporation.

2) Professional and Compliance Costs and Administrative Burdens

The costs to maintain a corporation are significantly larger than for a proprietorship. There are initial and ongoing legal costs and annual accounting fees to prepare financial statements and file corporate income tax returns. These costs can be significant in some cases and can even outweigh some of the tax benefits in certain situations.

In addition, the administrative burdens for a corporation are far greater and drive many a client around the bend. For example, in a proprietorship or partnership, the owner(s) can take out money from the corporation without payroll source deductions. This is not the case when the owner(s) take out money in the form of a salary from a corporation.

So Why Start as a Proprietorship?


If you do not have legal liability concerns and you cannot avail yourself to the enhanced income splitting opportunities with family members a corporation may provide, starting as a proprietorship keeps your costs down and reduces your compliance and administrative issues. More importantly, since most people need whatever excess cash their business generates in its early years to live on, there is generally little or no tax benefit from incorporating a business initially. Finally, a proprietorship essentially provides for an initial test period to determine the viability of the business and if there are business losses, the owner(s) can generally deduct these losses against his or her other income.

When to Incorporate your Proprietorship?


In my opinion, you should incorporate your proprietorship once it has proven to be a viable business and once it has begun to generate cash in excess of your living requirements, so that you can take advantage of the 30% tax deferral available in a corporation.

Once you satisfy the above two criteria and incorporate, you will then benefit from creditor protection and the potential income splitting opportunities with other family members (assuming you want to include other family members as shareholders) and potentially the capital gains exemption or multiplication of the capital gains exemption if you include other family members in the corporation.

There is no “one shoe fits all” solution in determining whether to incorporate a new or ongoing business; however, the answer should become clearer once you address the issues I have outlined in this blog.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Monday, February 8, 2016

Thanks for Reading

Last week I passed two million page views on my blog! Considering my topic area and the fact I write at most once a week, I am very proud of this accomplishment. I would like to thank you; my readers for helping me achieve this milestone.

Over the next couple months, I am going to try an experiment. Starting tomorrow, and then every second week, I am going to write blog posts under the heading "What Small Business Owners Need to Know". In these posts I will discuss topics such as inter-corporate dividends, corporate-owned life insurance, shareholder agreements and succession planning ("One Day You Will Sell the Business").

While these topics will be of greater interest to owners of small businesses, some of them, such as the post on life insurance will have a personal component; so you may want to at least scan through these, even if you are not a small business owner.

In the weeks I am not posting about small business issues, I have a couple blogs that deal with personal and estate issues for which I have high expectations. I will keep you in suspense on these, since there have been a few times when I or a guest poster have written a blog post I consider "excellent" and they turn out to be duds. While others times, I have written about what in my opinion are rather pedestrian topics and they turn out to be very popular blogs. So we will see if you share my opinion once these blogs are posted.

Until tomorrow... when I discuss how Intercorporate Dividends – Are Not Necessarily Tax-Free Anymore.

Monday, June 29, 2015

Should You Fund Your TFSA With Corporate Funds?

Many business owners and professionals operate through corporations. One of the main benefits of using a corporation is the deferral of income tax (over 34% in some provinces) and as a result, many business owners attempt to leave as much money in their corporation as possible (in essence to build their own mini corporate retirement fund).

When Tax-Free Savings Plans (“TFSAs”) were introduced in 2009, most small business owners typically had a choice of two pots of money to fund their annual $5,000 contribution limit. They could fund their TFSA with non-registered money (savings accounts or brokerage accounts) or withdraw funds from their corporations.

Initially, most chose to fund their TFSAs with non-registered money, since this money had already been taxed. However, as time marched on, many people exhausted their non-registered money in funding their TFSAs or used these funds for their personal use, such as to renovate their homes, vacations etc.

Funding an owner/manager’s TFSA has become even more problematic with the proposed TFSA increase from $5,500 to $10,000 announced in the March, 2015 budget. Some of my clients who do not have any available non-registered money to fund their TFSAs have automatically assumed they should fund their future contributions with corporate funds, as opposed to leaving the funds in their corporations and not funding their TFSAs.

Their thinking is premised on the belief that their TFSAs will provide for tax-free withdrawals in the future, while the money remaining in their corporation will ultimately be taxable when the funds are withdrawn as dividends.

As I have also been contemplating the question of whether you are better off funding a TFSA with corporate funds (via a dividend), or not funding a TFSA at all and growing a corporate "retirement account", I decided to run some numbers to see what they reflected.

Based on some simple calculations (provided below), the answer is not necessarily clear cut, although in general, it appears you will in most cases want to fund your TFSA with corporate funds. I provide some general guidelines below.

For the mathematicians out there, please do not have any heart palpitations. I concede a vigorous analysis would include various permutations, combinations and Monte Carlo simulations, but I have neither the tools, nor the time to undertake such an analysis.

The BBC’s Analysis


In undertaking my calculations I made some large assumptions.

1. The individual taxpayer is at the highest marginal rate (in Ontario).

2. The initial active income earned in the corporation was taxed at the lowest corporate rate of 15.5% (in Ontario).

3. I assumed a 30 year investment horizon and I used a flat 5% rate of return on the money, whether the income earned was interest, capital gains or dividends (of course in real life, typically the return on capital gains would be far in excess of that of interest and dividends), but you need to have a standard comparison point.

4. For purposes of this exercise, I assumed all dividends received are eligible dividends from Canadian public companies. 

What Did I Determine


My calculations reflected the following:

1. If you are earning interest in your corporation, you are clearly better off removing those funds via a dividend and investing the after-tax proceeds in your TFSA.

2. If all you are earning is capital gains, you are probably better off leaving those funds in your corporation, rather than removing the money via a dividend and funding your TFSA.

3. If you are earning eligible dividends in your corporation, you are better off removing the funds from your company. However, the timing and your marginal tax rate at the time could change that decision.

Since most portfolios earn a blend of interest, capital gains and dividends, depending upon the actual mix (this is why you would need to run your own numbers), you will likely want to use corporate funds to invest in your TFSA.

I should note that I did play around a little with income tax brackets. I compared the $44,701- $72,064 and $89,401-$138,586 income tax brackets to the highest marginal rate bracket. I determined that at the lower brackets, there is a slightly larger bias to funding your TFSA with after-tax corporate funds for all types of income, but the differences were not compelling.

As noted above, a rugged analysis would require multiple simulations which I don't have the tools to undertake. This analysis would take into account the different corporate tax rates, rates of return, income levels, future and current tax rates, income smoothing, portfolio allocation and investing style (some people only invest in higher risk equities that will produce capital gains in their TFSA - i.e. the greatest upside with no tax).

I would like to think this post was not an exercise in mathematical futility. Instead, I hope it gives you reason for pause in automatically assuming you should fund your TFSA with corporate funds, as opposed to leaving those funds in your corporation to grow over time. In order to ensure you make the correct decision, you need to review this issue with your accountant taking into account your specific income tax and investing circumstances.

The Calculations



Year 1
Corporate Income
19,763
Corporate Dividend
16,700
Income Tax 15.5%
3,063
Personal Tax 40.13%
6,700
Net Proceeds
16,700
Net personal
10,000



TFSA
Funds
Five %
Total
Return
Year 2
10000
500
10500
Year 3
10500
525
11025
Year 4
11025
551
11576
Year 5
11576
579
12155
Year 10
14775
739
15513
Year 15
18856
943
19799
Year 20
24066
1203
25270
Year 25
30715
1536
32251
Year 30
39201
1960
41161



INTEREST
Funds
Five %
Corp Tax
RDTOH
Net Return
Return
46.17%
26.67%
(A)
(B)
(C )
(D)
A+B-C
Year 2
16,700
835
386
223
17,149
Year 3
17,149
857
396
229
17,611
Year 4
17,611
881
407
235
18,085
Year 5
18,085
904
417
241
18,572
Year 10
20,653
1033
477
275
21,209
Year 15
23,587
1179
544
315
24,221
Year 20
26,936
1347
622
359
27,661
Year 25
30,762
1538
710
410
31,590
Year 30
35,130
1757
811
468
36,076
RDTOH
9,600
9,600
Dividend paid
45,676
Tax on dividend
Tax 40.13%
18,330
Net Proceeds
27,346

  
CAPITAL GAIN
Funds
Five %
Corp Tax
RDTOH
Net Return
Return
23.09%
13.33%
(A)
(B)
(C )
(D)
A+B-C
Year 2
16,700
835
193
111
17,342
Year 3
17,342
867
200
115
18,009
Year 4
18,009
900
208
120
18,702
Year 5
18,702
935
216
124
19,421
Year 10
22,585
1129
261
150
23,453
Year 15
27,274
1364
315
181
28,323
Year 20
32,938
1647
380
219
34,204
Year 25
39,777
1989
459
265
41,307
Year 30
48,037
2402
555
319
49,884
43,146
9,962
5,738
Capital dividend        50%*$43,146
-21,573
Funds available for dividend
28,311
RDTOH paid out
5,738
5,738
Dividend paid
34,049
Tax on dividend paid
Tax 40.13%
13,664
20,385
Capital dividend paid out tax free
21,573
Net proceeds
41,958





ELIGIBLE DIVIDEND RECEIVED

Funds
Five %
Part 4 Tax
RDTOH
Net Return


Return
33.33%
33.33%


(A)
(B)
(C )
(D)
A+B-C
Year 2
16,700
835
278
278
17,257
Year 3
17,257
863
288
288
17,832
Year 4
17,832
892
297
297
18,426
Year 5
18,426
921
307
307
19,041
Year 10
21,709
1085
362
362
22,433
Year 15
25,577
1279
426
426
26,430
Year 20
30,134
1507
502
502
31,139
Year 25
35,503
1775
592
592
36,686
Year 30
41,828
2091
697
697
43,222
RDTOH
39,782

13,259
13,259
Dividend paid

56,481
Tax on eligible dividend ($39,782*.3382)

-13,454
Tax on ineligible dividend ($16,699*.4013)

-6,701
Net proceeds

36,326




Note: I apologize for the formatting on the dividend chart. I made a change and now cannot get it back to its original format.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.